The situation
A few weeks ago, a quote request arrived for a new product. It had high volumes, and it was an excellent fit for your facility.
You ran it through your estimating program, submitted your price, and then you got the dreaded call. The buyer told you, “Your prices are double-digits too high.”. You don’t know how that could be. Your margins are already skinny. How can somebody else be doing it so cheaply?
You say to yourself, “We can’t compete on this commodity stuff. The competition must have ______ (insert your favorite reason – offshore manufacturing, better material prices, new equipment, low profitability).
The cost of complexity
I usually hear this frustration from companies that pride themselves on their ability to do the complex, difficult projects. Over the years, they’ve developed a technical proficiency that enables them to do things that other companies can’t do. They have grown the ability to deliver exceptional quality, produce to tight tolerances, deliver superior customer service, and comply with onerous customer-mandated requirements.
The company is justifiably proud of these accomplishments. However, it’s important to realize that developing these capabilities came at a cost, and over time these costs just became normal. They evolved into “the way we do things.” Over the years these costs climbed and were rolled into the overhead structure, eventually becoming part of the burden rate. Once they were part of the burden rate, they became part of estimating and then the quote to the customer.
In my experience, eight times out of ten, the inability to compete on price is driven by the high burden rate and not by the cost of direct labor and materials.
A real-life example:
This year, I worked with a client who quoted a very large job, and the customer informed them that they were “double digits high.” My client assumed that somehow the competition was buying material much less expensively. When we peeled that onion, we decided that was a nonsensical explanation. We knew enough about the competition to know that they might be buying materials a little bit better, but not enough to explain the price gap.
The real issue was that the competition was a no-frills shop. They ran with little overhead, and therefore they could live with a lower markup over the direct costs. The customer didn’t want all of the fancy, complex stuff that my client could offer. The quote was for a bare-bones, high volume, low-variety product.
We decided to do a mental exercise. We analyzed what the costs would look like if WE were a bare-bones shop like the competition? What would it take to run this job? What kind of cost structure would we have in place to run this job?
When we stripped out the complexity of the business that was built into the overhead rates, the company was able to compete quite well and generate very healthy profits.
Costing systems can mislead us
Costing systems have existed since the early mass-production days of the auto industry, and in many cases, they are built on false assumptions that can mislead decision-makers. It often results in overloading the easy, vanilla jobs with overhead costs they shouldn’t bear, leading management to believe that they aren’t competitive on easy products. The flip side is also true. The complicated jobs are often not bearing their fair share of the overhead costs, making them look artificially profitable.
It is usually enlightening to look at the profitability of jobs when you do a simplified activity-based-costing study to assign the overhead costs to the products that are truly driving those costs. You may get a new perspective about where you’re making money.
What to do?
What should you do if you have one of these great jobs to quote and you’re concerned about being double-digit high? Here are a few pointers:
- Focus on dollars, not percentages. A project may have a low margin percent, but it may generate significant profit dollars for the company. Analyze the attractiveness of the business based on the dollars.
- Use the real cost of labor and the real cost to run the machines – not burdened rates.
- Identify the overhead costs that will be added if you won the job. Would you need more engineers, quality techs, or customer service reps? Don’t just layer on the standard overhead rate. Do the analytical work to figure out what types of overheads this particular job would need.
- Evaluate your capacity. Can you take on this project without adding production capacity? The business economics are quite different between a factory running at capacity vs. one that has significant idle capacity.
If you have any questions, let’s talk. The addition of a couple of high-volume, simple-to-run jobs can have an enormous impact on financial performance. I’d love to work the numbers with you.